The housing dilemma...

Housing has been at the center stage of the current economic crisis ever since the sub prime blowup of August. Apart from the fact that pretty much every indicator out there suggests that the real estate market in the U.S. is in a recession, there is growing concern that the worst is still to come and the implications of this on the rest of the economy. The worry is clearly regarding the risk of contagion or a spillover. So far nothing would suggest that the damage is spreading beyond the housing borders but this could very well be because of a lag factor. Studies suggest, for example, that for every 100 dollar drop in financial wealth, the consumer will spend from between 2 to 5 dollars less on consumption. For every 100 dollar drop in housing, on the other hand, consumption drops between 5 and 9 dollars. Apart from the difference in the drop in consumption, it has been shown that the effect of a drop in financial wealth is pretty much immediate, in contrast to a drop in the price of housing in which there tends to be a clear lag (sometimes substantial) before it translates into less consumption. Hence, this could explain why consumption has not retracted despite falling prices. Considering that consumers make up roughly 70% of GDP, this is a very big deal (and unlikely to be offset by exports or a so far resilient stock market).
Considering a stock market that is still in the black for the year and gasoline prices that have yet to reflect the sharp rise in oil, the housing slump on its own wont cause much damage. But if we factor in a possible scenario in which there is a sharp correction in the stock markets, more credit tightening across the board and a sharp rise in gasoline prices (which is bound to occur if oil continues to hover around $100), things could rapidly turn ugly.

Staying the course...

If we take the definition of a bear market, which is a stock market drop of at least 20% in a 12 month period, Japan, or more specifically the Topix index should in fact be considered to have entered bear territory. This is bearish news indeed, considering Japan happens to be the second largest economy in the world! What about China, where the Shenzhen index has shed close to 18% from it's peak? If the index breaks the 20% barrier would that be considered a bear market (considering that from trough to peak this year it has returned close to 176%)?
Irrespective of the debate on how to detect a bear market it has been demonstrated time and again that during periods of crisis (like the one the global markets are currently experiencing), emotions tend to override rationality. It comes as no surprise considering that our ancestors used these very behavioral attributes very effectively for survival. Employing them in investing, however, has proven to be highly destructive. Take the '87 crash as an example. The stock market correction sparked a bond market rally (similar but more pronounced than today). Most investors that held on to their stock portfolios right after the crash eventually gave up and switched their investments into bonds more or less around the time when the bond market rally peaked. What resulted was a double carnage for not only did they lose a large chunk of value from their stock holdings but, right after the switch, when stocks picked up and the bond rally ended, they experienced a further erosion of their wealth. The lessons to be learned from this is to avoid being overwhelmed by our emotions in difficult times, to stay the course by focusing on the longer term objectives and rebalance whenever necessary.

Options on the table...

We know that Fed has two mandates (both enacted by congress) which may be broadly defined as insuring market stability to maintain unemployment at its natural rate (whatever that may be) and price stability to ensure that inflation is basically tamed. History also shows us that, at times, the economy may find itself in a position whereby on the one hand we have deteriorating market conditions with unemployment rising and, on the other hand, there are signs of inflationary pressure. Stagflation is usually the term coined to describe an environment in which there is rising inflation combined with stagnant growth and rising unemployment (a prelude to a recession). The U.K. experienced stagflation in the 60's and 70's whilst the U.S. economy was in stagflation during the Carter administration of the 70's. The reason why is so dreaded by governments and central banks is because the main tools at their disposal, namely fiscal and monetary policy become ineffective. This is not to say that the U.S. is in a stagflationary state or that it is heading in that direction (the world has evolved so much and the same principals may not apply anymore). But it is clear that the Fed is having to make a difficult choice between providing market stability and capping inflationary pressure. Right now they are erring on the side of market stability to avert the risk of a recession. We could argue that they are walking a thin line because not only do they need to fine tune between the employment/inflation trade off, but, now that they are leaning towards the side of providing market stability they need to concern themselves between the market stability/moral hazard trade off. Market stability will indeed raise the probability of averting a full blown recession, but it will most likely come at a price in the form of more reckless activity amongst market participants once the stability sets in. These are indeed very challenging times for Bernanke and his crew!

Running out of oxygen

It is awkward to observe a resilient stock market in the wake of a substantially weakened dollar and record oil and gold prices. We can explain the record in gold prices by not only the imbalances in demand/supply (fuelled by growing consumption coming from commodity rich nations and India and also from growing use of this commodity in manufacturing) but also as a result of its traditional role as a refuge investment (currently boosted by the shrinking dollar and the growing pessimism on the economy). Oil prices, on the other hand, are dictated not only by demand/supply imbalances and speculation, but also by a geopolitical risk premium. This risk premium is playing an increasingly important role in explaining oil price fluctuations, considering the emergence and growing importance of Russia, Iran and Venezuela (all three amongst the top five petroleum producers) forming an increasingly confrontational alliance against the U.S. and, to a lesser extent, Europe.
With the level 3 assets issue looming as the latest twist in the subprime/credit crunch debacle and a consumer market feeling increasingly squeezed by rising costs and a shrinking wealth effect, it is difficult to maintain an optimistic view with regards to the economy. Even the hope of a possible decoupling combined with a heavily depreciated dollar coming to the rescue stands on shaky grounds considering the insane market multiples as observed in China and elsewhere. One could argue that we have not as yet reached the apex of the current crisis.

The Fed in observation mode...

Yesterday's quarter point cut was very much in line with market expectations, reflecting a Fed that, although remaining weary of the risk of a housing spillover, was reacting more to the build up in anticipation in markets that are still reeling from the July-August shock. With the most recent economic releases suggesting more inflationary risk (tight labor markets, high capacity utilization and a surprisingly strong third quarter GDP) to come and a weak dollar with oil trading at record levels, the Fed took the opportunity to clarify its stance as to the future direction of rates. The message was there was far too much uncertainty in the markets and that the future direction of rates would depend on how the current crisis unfolds.
Although the housing slump seems to be contained for the time being, tightening lending standards and higher gasoline prices at the pump are bound to influence spending patterns. To counter this we have the weaker dollar combined with healthier growth outside of the U.S. but there is talk that certain emerging markets, most notably China, are entering or are already in a bubble. The longer this remains true, the more difficult it will become to engineer a soft landing.